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Home , Demand for money

Journal of and International Finance Vol. 3 (15), pp. 771–779, 7 December, 2011 Available online at http://www.academicjournals.org/JEIF DOI: 10.5897/JEIF11.118 ISSN 2006-9812 ©2011 Academic Journals

Full Length Research Paper

The determinants of the demand for in developed and developing countries

Yamden Pandok Bitrus

Department of Economics University of Jos, P. M. B. 2084, Jos, Plateau State, Nigeria. E-mail: [email protected]. Tel: 234-8032104525.

Accepted 15 November, 2011

This study examined the determinants of the demand for money in developing and the developed countries. The study employed a comparative analysis of the effectiveness of the determinants of the demand for money in both developing and developed countries. It was found out that income related factors or the scale variables are more effective in the developing countries while factors that work through the financial system are more effective in the developed economies and that stock variables should not be ignored in modeling demand for money even in emerging economies since they constitute an alternative to holding cash. The level of the development of a country’s financial system determines which factors will be relevant targets in moping excess liquidity within an economy.

Key words: Demand for money, comparative analysis, excess liquidity.

INTRODUCTION

According to Black (2003), demand for money refers to developing countries. The rest of the paper is organized the amount of money people wish to hold or the function as follows; theories of the demand for money, determining this. In other words, it is referred to as the comparative analysis of the relevance of the desire to hold cash. The demand for money arises from determinants of the demand for money in developed and two important functions of money; developing countries and conclusion. and the store of . The study of the demand for money is not restricted to the , but also involves other market such as the commodity, capital and THEORIES OF DEMAND FOR MONEY foreign exchange market According to Jhingan (2004), demand for money arises The purpose of the theory of demand for money is to look from two important functions of money. The first is that at the variables that motivate people to hold part of there money act as a medium of exchange and the second is wealth in money as opposed to other assets. According that it is a . Thus individuals and businesses to Jhingan (2004), there are three approaches to the wish to hold money partly in cash and partly in the form of demand for money: assets. Why do individuals desire to hold money? In an attempt (1) The classical approach; (a) the equation of exchange; to answer this question, several made b) the cash balance (Cambridge) approach several assertions on the reason(s) why people hold (2) The Keynesian approach money. With his conceptual framework, Keynes (1936) (3) The post Keynesian approach laid the foundation for the development of all modern theories on the demand for money hence regarded as the father of modern theories of money demand. Classical approach This paper examines the contribution of various schools of thought in on the demand for The classical economist did not explicitly formulate money. The study then examines the relevance of the demand for money theory but they emphasized the determinants of the demand for money in developed and for money in terms of the velocity of 772 J. Econ. Int. Finance

circulation of money (Jhingan, 2004). This, according to value function of money – even though they expanded the classical economist, is because money acts as the the scope of the demand for money. Keynes, a product of medium of exchange and facilitates the exchange of Cambridge, further extended the concept of the demand and services. There views were expressed in the for money in two of this works on money, a on fishers equation of exchange; monetary reform (1923) and a treatise on money (1930). Examining why the demand for money depends MV = PQ negatively on rate, Keynes published “The General theory of employment, interest and money” in where, M = the quantity of money; V = its velocity of 1936. circulation; P = level and Q = total output Keynes (1936) introduced three reasons or motives for holding money; the transactionary, precautionary and the Here, MV = , while PQ represents the speculative or portfolio motive. Each of these motives is demand for money. At equilibrium, money demand (PQ) associated with one component of the demand for money equals money supply (MV). The underlying assumption in examined by Keynes. the equation of exchange is that people hold money to buy goods and does not explain fully why people hold money. Transactionary demand for money In a slight contrast to the fisher version introduced by of yale in the early 1900‟s, the Cambridge This arises from the need to hold cash for current version introduced by economist of the Cambridge personal and business expenditure. There is hardly any University of England raised a further question: why economic unit whose cash receipt perfectly matches its would individuals want to hold there assets in the form of cash payments at all times. Monthly salary earners cash?. The Cambridge demand equation for money is receive their remuneration on monthly basis, some d d represented by the equation M = KPY where M = weekly and some on bi-monthly basis but not all demand for money, K = is the fraction of real money, foodstuffs could be bought and stored up till the next incomes individuals want to hold in the form of cash, P = salary period. Even if this possible, other expenses like is the and Y = is the aggregate real income. transport to work and newspaper will have to be on daily Assuming a year consists of 12-4 week months, that is, basis or at shorter intervals than receipt or income. 48 weeks. Considering the case of an employee who is The situation appears similar for must business goods paid N2,800.00 once a month, or N33,600.00 a year and may have to be sold on credit or on monthly billings but who spend his income evenly – N100.00 a day – over the daily expenses have to be made. Even for government, 28 day month. The moment the individual received his most company tax and trading surplus of monthly income, he holds N2,800.00. The next day, he government owned corporations accrue mostly at year holds N2,700.00 (having spend N100.00) the day after he ends but again daily expenses will have to be met. The holds N2,600.00 and so on until the 28th and last day of diversity in the timing of inflow and outflow of funds the month when he spends the remaining N100.00. create the need to hold some cash to meet daily Dividing the individual‟s average money holdings of expenses till the next cash inflow period. N1,400.00 by his income (expenditure) of N2,800.00 we Therefore, the higher the level of income of an find the Cambridge “K” which is ½ which means that the economic unit, the higher will be the transactions demand individual‟s average holdings of (demand for) money is ½ for money and vice versa, hence Mt = F(Y) where F > 0. of his monthly income which is equivalent to 1/24th of his The important thing to note here is that while Keynes annual income. explicitly recognize that the transactions demand for Suppose that employees are paid once a week instead money (Mt) depends on , he argued that the of once a month, with the same income the employee will influence of interest rate was minor compared to that of receive N700.00 a week which he spends. The income individual‟s average income is N350.00 which is ½ of his weekly income and 1/96th of his annual income in cash. This demonstrates that the more frequently employees Precautionary demand for money are being paid; the lower will be their demand for money. It is evident therefore, that the Cambridge approach The precautionary demand, according to Keynes arises stressed the importance of other variables that influence from the need to provide for unforeseen event requiring the demand for money at any point in time. sudden expenditures. Unforeseen events as ill health, accidents and robbery/theft happen so sudden hence the need to hold cash to meet such unexpected cash needs. The Keynesian perspective The higher the level of income of an economic unit, the higher will be the precautionary demand for money by the According to Jhingan (2004), one of the major criticisms individual or the higher will be the money needed to meet of the Cambridge version is their neglect of the store of unexpected expenditures and vice versa. Hence Mp = Bitrus 773

F(Y), F > 0. While Keynes explicitly recognized that that individuals would hold their wealth in bonds or precautionary money demand depends on interest rate, money, that is, they would not diversify their portfolios. he argues that the influence of interest rate was minor This was remedied by Harry Markowitz and . compared with that of real income. In addition and James Tobin also provided the theory that explains why the transactions demand and even the precautionary demand depends on The speculative demand for money the interest rate.

The speculative demand according to Keynes arises from uncertainty about future interest rate. Keynes James Tobin’s explanation emphasized risk and the uncertainty of expectations as the reasons behind the negative relationship between the Tobin noted that the Cambridge approach merely asserts interest rate and the speculative demand for money. For that an individual must hold one-half of the periods example, in general theory, he wrote that “uncertainty as receipts (and expenditure) as transactions balances. It to the future course of the rate of interest is the sole does not specify the form in which these balances are intelligible explanation of this relation.” Through held. According to Tobin, if an employee is paid salary speculative demand for money, Keynes extended (for example N3,000 in 30 days), he can deposit all in another function of money, that is, store of value. In this bonds and then visit the broker to liquidate N100 worth of function, there are two component parts; the transaction bonds until the holding is completely liquidated. The demand which is a positive function of income while the demand for money diminished as the number of transfers demand for securities (bonds) are negatively related to between money and securities increases. The marginal interest rate. The determinant of the demand for bonds is revenue (MR) from each transaction with the broker is the the price of bond and the interest on bonds. The higher extra interest earned by holding more securities and the level of interest rate, the lower is the speculative fewer money balances. As the number of transfers demand for money and vice versa. increases, the marginal revenue from each transfer The speculative demand for money is fairly elastic diminished. The (MC) consists of the initially, but after a level, it becomes perfectly elastic. This brokerage fees, or transaction costs, of transferring perfectly elastic region of the demand curve for money is securities to money and vice versa. The cost includes the called the . The critical interest rate is at its “time and trouble” of switching between securities and lowest level and cannot go below that. According to money. The marginal cost (MC) curve is horizontal Keynes, if a person decides to keep bond instead of indicating a constant marginal cost (MC) of each transfer. cash, he is speculating that the future interest will not rise The optimum number of transfers is determined at the but if he speculate it will increase, then there will be no point of equality between the MR and MC. The number of need to buy it. Therefore, it is the uncertainty in the future transfers determines the demand for money (Figure 1). level of interest that induces the speculative demand for money. An inverse relationship exists between the price of William Baumols explanation 1 bonds and the interest on bonds (Po = R/(1 + r) ). Anybody buying a bond has an expectation that in future, Baumol called his approach the inventory – theoretic market conditions will be such that the rate of interest will approach. To find the optimal quantity of transactions not change in a way that a capital loss will be anticipated. balances that an individual should hold, Baumol applied Anybody who switches from bond to money holds the optimizing techniques previously used to find the optimal expectation that market interest will increase while the inventory of goods that a firm should hold. In Baumols person that switches from money to bond expects market analysis, the demand for transactions balance depends interest to fall. The belief is that the current market on brokerage costs and the of deposits. interest rate is too high and those who switch from bond Baumol assumes that every time an individual buys or to money hold the opposite expectation. Therefore, the sells bond, he or she incurs a brokerage fee, denoted by higher the level of interest today, the lower is the amount b, with “n” transactions. The brokerage costs equals “bn”. of money left for speculative reasons and vice versa. Brokerage costs are one of two components of the total cost of security transitions balances. The second component is interest forgone by holding wealth in money Post Keynesian approach (deposits) rather than in securities. This opportunity cost d of money equals (i - rD) M . Thus total costs, TC, are By using the store of value function of money, Keynes introduced the interest rate as one of the factors affecting Total costs = Brokerage costs + opportunity cost money demand through the speculative motive. This d however, suffered from a shortcoming; Keynes predicted TC = bn + (i - rD) M (n = Y/T) 774 J. Econ. Int. Finance

M R1 M C

MC

MR

0 N1 N (number of transfers)

Figure 1. Marginal Revenue and cost of switching from money to securities and vice versa.

Therefore the brokerage cost are b(Y/T) also, Md = T/2 ’s explanation TC = b (Y/T) + (i - rD) x (T/2) The individual is now faced with the problem of Friedman‟s contributions to the deciding on the amount of funds to convert from bonds to are a restatement of money demand by the classical cash at each withdrawal in order to minimize total costs. economist. According to Friedman, investors can hold Determining the optimal size of T also gives us the size of their wealth in the form of money, bonds, equity shares money demand. The investors aim is to choose the level and commodities. He concludes that the demand for of T that minimizes total cost, that is the optimal values of money depends on rates of return of the four assets and T . Therefore by differentiating TC with respect to T, upon income. Assuming bond and equity capital are setting the derivative equal to zero and solving for T we perfect substitutes, with equal rates of return, freedman‟s obtain; money demand function is;

d d M = M (i, rD ∆p/P, Y, W) T = by/i – rD where Md = money demand; P = price level (positive); i = Since Md = T/2 it follows that Interest rate (negative); Y = income (positive); W = Wealth (positive); rD = deposit rate (negative) d M = ½ 2b Y/i – rD (the famous square – root rule) According to him, all things being equal, an increase in the expected rate of increase the demand for Where , Y = Income; = Brokerage fee; T = number of commodities and reduces the demand for money and vice versa. transaction; i = Interest rate; r = Deposit rate D

The transaction demand is directly proportional to the COMPARATIVE ANALYSIS OF THE EFFECTIVENESS square root of the quantity of transactions and inversely OF THE DETERMINANTS OF THE DEMAND FOR proportional to square root of the opportunity cost. In MONEY IN DEVELOPED AND DEVELOPING other words, if the opportunity cost increases, it will be COUNTRIES profitable to invest in bonds and the optimal cash balance ill reduce. According to Jhingan (2004), money refers to demand Bitrus 775

deposits with commercial banks plus with the where W = wealth; rD = deposit rate. public which are together denoted as M1. This is regarded as a narrower definition of money. Friedman (1956) proposed a broader definition to include time deposits of Level of income and money demand commercial banks hence the broader demand for money is M2 = M1 + time deposits. Even though time deposits The major determinant of a nation‟s demand for money is posses‟ liquidity hence regarded as money, Friedman the volume of payments that must be undertaken. A good (1956) referred to it as a temporary abode of purchasing measure of the volume of payments, in turn, is the level power as it stresses the store of value function of money. of national income (Y). All things being equal, the higher In any case, depending on the level of development of the level of income, the greater the need for money and, the financial system of a country, some assets that are hence the greater the demand for money and vice versa. not liquid can be categorized as money due to their moneyness as created by the development of a financial system. The more developed the financial system of a Realities in developed economies country, the higher the liquidity of illiquid assets. According to Kumar et al. (2011) many developing countries have underdeveloped, undiversified financial In the developed world, with an organized financial markets that lack financial sector instruments and market, an individual‟s income is of a lesser degree in payment technologies such that most transaction involve determining the amount of money an individual will hold. the use of narrow money. In the first instance, their payment system is convenient In determining the variables of the demand for money and not in the form of liquid cash. More so, the easy function, there are two sets of variables. The first sets are access to credit compared with the developing world referred to as the scale variables (related to the impact of means more expenditure can be made without cash, for income or wealth) while the second set are the example mortgages, telephone bills, hospital bills, opportunity cost variables (related to substitution based newspaper delivery. This reduces the public desire to on relative attractiveness of assets regarded as hold cash. Even though lesser income is substitutes of money). Owoye and Onafowora (2007) expected in developed countries compared with the opined that economic agents may hold money either as developing world, Mark and Sul (2003) cited in owoye an inventory to smooth differences between income and and Onafowora (2007) found income elasticity greater expenditures, or for its yield as an asset in a portfolio. than one in 10 of the 19 advanced countries they According to them, either motive suggests a specification examined in their study. in which the demand for money depends on a scale variable such as real income or wealth and the rates of returns to money and that of alternative assets. Realities in developing countries Therefore, we specify the demand for money function by adopting the model used by Kumar et al. (2011); Income is the most significant determinant of money demand in the developing countries. The higher the In Mt = θo + θy In (Yt) + θR Rt+ θE In Et + θπ πt + Et income of an individual, the higher will be that individual‟s demand for cash and vice versa. The relative where θo = intercept, Y = real output; R = short term underdeveloped financial system means that individuals interest rate; M = real narrow money stock; E = effective cannot finance their deficits from funds derived from the financial market hence the need to keep large proportion We specify our demand for money function based on of their income in cash. The relative absence of financial this model as assets means that even if the people want to buy them, they will not get them hence hold more cash balances. Md = F (Y, R, E, INF) According to kumar et al. (2011), Many developing countries have underdeveloped, undiversified financial markets that lack financial sector instruments and where Y = income; R = interest rate; E = exchange; INF = payment technologies such that most transactions inflation rate involve the use of narrow money hence one should expect income elasticity slightly above unity. Anoruo But there are other determinants of lesser impact which (2002), Akinlo (2005), owoye and onafowora (2007) and were captured by the disturbance term in their model Nwafor et al. (2007) found income elasticities of 5.700, which we may want to include in the work. Hence the 1.094,2. 067 and 5.430, respectively for Nigeria while demand for money function will be thus; Darrat (1986), Nell (2003) and Drama and Yao (2010) found income elasticities of 1.843, 1.480 and 5.312 d M = F (Y, R, E, INF, W, rD) respectively for Kenya, south Africa and Cote d‟Ivoire. 776 J. Econ. Int. Finance

The interest rate and money demand sheet of banks who are the suppliers. Other things being equal, the quantity of deposits rises as the deposit rate The level of interest as a major determinant of money increases hence positively – sloped (Figure 2). The demand was first introduced by Keynes and has since, supply of deposits increase when the marginal been a major determinant of money demand. The theory revenue of issuing deposits [(I – rr) I = rD) rises. Therefore holds that the higher the level of interest, the lower will be all things being equal, when the deposit rate falls, profit the individual‟s desire to hold cash because of the maximizing banks want to issue more deposits because increase in the opportunity cost of holding cash as the net marginal revenue rises hence negatively slopped. opposed to interest bearing assets and vice versa. This Demanders and suppliers of deposits interact in the means that there is an inverse relationship between the market for deposits in which the deposit rate moves to demand for money and the level of interest. make their plans match at point „E‟ in the diagram /AB/ shows excess demand where the public wants to hold more deposits than banks would want to issue, the Realities of developed economies converse is denoted by /CD?

In the developed economics there is an existence of an organized financial market with wide range of financial Realities in developed economies assets. Therefore, the substitution between money and financial assets is highly existent hence more people are With a developed financial system with limited asym- predisposed to holding at least one form of financial metric information, people are more likely to be assets or the other. With limited or no asymmetric influenced by the deposit rate and take notice when it information, individuals demand those securities with increases or decreases. The higher the deposit rate, with higher interest in line with theory that the higher the individuals doing more transactions through banks, the interest rate, the more the demand for that asset and the higher will be the demand for deposits and the lower the lesser will be the desire to hold cash (money demand) money demand. More transactions through banks and vice versa. With the developed financial market increase the likelihood of the demand for money specialization leads to efficiency by reducing the balances to be affected by the deposit rate in the hence relativity high demand for assets economy. compared to the developing world.

Realities in the developing countries Realities in developing countries In the developing economies, most people handle their In the less developed economies, the financial sector is transactions through the unorganized informal sector, underdeveloped, hence limited financial assets supplied and are mostly unaware of activities in the organized by the market. Most individuals do not have easy access market hence not likely to be influenced much by deposit to financial institutions and with the high transaction cost, rate. Therefore any policy aimed at moping liquidity the attractiveness of financial assets decline. through the deposit rate will not yield much hence Furthermore, with the negative influence of asymmetric undermining deposit rate as a determinant of the demand information, the interest of individuals in financial markets for money in the developing countries. diminish as the of transactions increase, hence, they keep more of their wealth in the form of cash (the higher the demand for money balances). The low Wealth and the demand for money level of income means people hardly satisfy their basic needs hence limited speculative demand which reduces Wealth is a major determinant of the demand for money. the influence of interest rate in the demand function for An individual who has large wealth would be expected, money in these countries. According to Owoye and within the framework of portfolio theory, to have more of Onafowora (2007), the structure of the financial markets each of the various assets that are accommodated in his in less developed countries renders interest rate targeting wealth portfolio. These assets would include money. ineffective. Taylor (2004) cited in their work stated that if When the wealth holding increases, demand for money financial markets are weak, the effectiveness of will be expected to increase just as the demand for other transmitting policy through interest rates will be limited. assets will be expected also to increase within the portfolio framework.

Deposit rate and the demand for money Realities in the developed countries Deposits are asset in the balance sheet of the public, who are the demanders and a liability in the balance Although wealth is expected to influence the demand for Bitrus 777

rD Dy A B rD3

rD1 E

rD2

Ds

0 D 1 Dy, Ds The deposit market THE DEPOSIT MARKET

Figure 2. The demand and supply of deposits.

money by individuals in every society, the impact of Realities in the developed economies wealth is smaller in the developed economies compared to the developing countries. The reason is due to the The develop economy is associated with relatively stable developed financial system where the individual has ; hence, panic demand is not frequent therefore other interest-bearing assets at his own disposal and the undermining price changes as a determinant of money value system which is not inclined towards ostentation. In demand. Stable prices mean stable demand for money the first instance, holding cash is expensive to him and balances over time. the value system does not encourage unnecessary spending hence, likely to keep smaller fraction of wealth in cash. In contrast, he invests in acquiring interest- Realities in the developing economies bearing assets. With the unstable prices in developing countries at any point, prices are expected to rise hence panic demand is Realities in the developing economies the order of the day. With inflationary tendencies high, the demand for money balances will be low due to the The size of wealth influences people‟s choices between unexpected demand for , for example money and interest- bearing assets. With an petrol in Nigeria, therefore, price is an important underdeveloped financial market, and the value system determinant of the demand for money in the developing of ostentation, wealthy people keep more cash balances countries. (wealth) to show-off, hence, wealth is an important variable of money demand in the less developed economies (LDC‟s). Other factors include

There are other minor factors that influence the demand Inflation and the demand for money for money in developing and developed countries.

When people expect general price level to rise, there is a mad rush to purchase commodities and hence less Exchange rate and the demand for money demand for money balances. The uncertainty and Instability in the level of prices reduces people desire to The return on the holdings of foreign assets will be in- hold more of cash by increasing panic demand for goods fluenced by the expectation of exchange rate movements and other properties hence lesser demand for money. (Essien et al., 1996). According to them, depreciation of 778 J. Econ. Int. Finance

depreciation of the domestic currency relative to foreign Required reserve and the demand for money would lead to a rise in the return on foreign assets to domestic holders and vice versa. They stated An increase in the reserve requirement ratio reduces further that attempt should be made to capture the bank profit per naira of attracted deposits, thereby influence of exchange rate expectations on the return on inducing banks to reduce the deposit rate. Similarly, an foreign assets. That this could be done by either increase in the marginal cost of servicing deposits also adjusting the foreign interest rate for exchange rate ex- reduces banks‟ profitability inducing banks to lower the pectation or by introducing the exchange rate expectation deposit rate, thereby, increasing the public‟s demand for as a separate variable in the money demand function to deposits and reducing the public‟s demand for money be able to identify the separate effects. They however and vice versa. used exchange rate rather than foreign interest rate as a measure of currency substitution in Nigeria. Payment habit and the demand for money

Stock market and the demand for money Payment habits differ from society to society – some monthly, bi-monthly, weekly and daily. The more the Conceptually, money is an asset with a particular set of frequency of income payment (salary) per period, the less characteristics, most notably its liquidity (Carpenter and will be the demand for money in the society and vice Lange, 2002). Like other financial assets, demand for versa. money is part of a portfolio allocation decision, in which an agent‟s wealth is distributed among competing assets based on each asset‟s relative benefits (Tobin, 1969). To Conclusion a certain extent, agents are willing to give up the higher return of alternative assets in order to receive the benefit In the analysis, there are several factors that determine of liquidity that money provides. the demand for money in both developing and developed Thus, according to Carpenter and Lange (2002), stan- economies. Factors such as income, interest rate, price dard money demand equations include an interest rate or level, deposit rate, wealth, required reserve, individual interest rate spread to measure the opportunity cost of , payment habit and brokerage fee/risk, all holding non-interest earning money. This is true in the determines the desire of people to hold cash (demand for sense that since opportunity cost is the cost of alternative money). foregone, a higher return on alternative assets depletes In any case, the development of the financial system of liquidity (cash holding). In their work, Carpenter and a country determines which factors are more relevant in Lange (2002) concluded that a standard money demand determining the demand for money in that country. There model can be improved by including equity market are factors that work through the financial system such as variables. the interest rate, the deposit rate, required reserve ratio and brokerage fee (opportunity cost variables). When the financial system is underdeveloped, these factors work Individual preferences and the demand for money less or are not effective in determining the demand for money. Therefore, any policy aimed at moping liquidity The importance that people attach to money as a form of through these factors will likely not yield any result. wealth, given the same level of opportunity cost, will vary Finally, the underdeveloped nature of the financial and thus will affect the individual‟s demand for money. systems of the less developed economies (LDC‟s) means Some people attach enormous value to the convenience income-related factors (scale variables) are more of liquidity and confidence which money possess, such effective in determining the demand for money balances. individuals believe that the liquidity and confidence that Changes that are income related will proof effective in money generates constitutes some form of implicit yield changing the level of liquidity in any economy of the less and it is a comparison of this implicit yield with the explicit developed countries. yield, which is the interest foregone. This actually influences a person‟s propensity to hold cash. REFERENCES

Brokerage fees and risk Akinlo AE (2005). „The stability of money demand in Nigeria; an autoregressive distributed lag approach‟. J. Policy Model., 28: 445- 452. Other things being equal, an increase in brokerage cost Anoruo E (2002). „Stability of the Nigerian M2 money demand function increase in brokerage cost increase money demand and in the SAP period‟. Econ. Bull., 14: 1-9. vice versa. So also an increase in the appetite for risk Black (2003). „Oxford Dictionary of Economics‟. Oxford University Press, p. 114. decreases the demand for deposits and hence increases Carpenter SB, J Lange (2002). “Money Demand and Equity Markets”. the desire of the public to hold cash (demand for money). Board of Governors of the Federal Reserve System and Cornerstone Bitrus 779

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